Thornburg Value Fund Q2 Letter To Investors
For the U.S. equity markets, the second quarter of 2014 felt a bit boring.
As of this writing, the S&P 500 had made it 57 days without moving up or down more than 1%. This is the longest such streak since at least 1993. Indeed, if you were to walk around the trading floor of almost any investment shop during the quarter, you'd hear "low volatility" muttered over and over again. This is, of course, just another way to say "boring."
It was, in fact, a very strong quarter for the Value Fund's benchmark S&P 500 Index, which returned 5.06%. In the context of that strong upswing, the fund's A shares nearly kept pace, at 4.73%, without the inclusion of the sales charge.
But the flip side of low volatility is complacency. And, we see a lot of it about, especially in the fixed-income markets. One metric that gives us pause: The percent of bank loans issued with fewer investor-protecting covenants has reached an all-time high, surpassing even levels seen in 2007, as Chart I below shows. Broadly, fixed-income markets globally are expensive, having been bid up to artificial highs by central banks all over the world. There is, quite simply, very little for value-oriented bond managers to get excited about. Those full valuations haven't been limited to just the asset classes central banks have bought directly, but include virtually every risk asset out there. And, pockets of very high prices can't simply be considered benign.
Within the equity markets, stability is now at a premium. Stocks that are most "bondlike," ironically, are the most expensive. Investors are paying big multiples for stability. Where consumer staples, such as Coke, had previously carried high relative multiples, now it seems that anything with stability is priced high. Blame, once again, the U.S. Federal Reserve, as risk-free rates pegged at zero have tended to push everyone out the risk curve.
That said, we see some promising signs for the U.S. economy. For example, the age of capital stock-the equipment owned by private enterprises in the United States-is now as old as it has been in at least 40 years (see Chart II). So far, during this recovery, capital expenditure on this sort of equipment has been low. Corporations have allocated excess cash flow to dividends and share buybacks instead. With a healthy rate of job creation and signs of wage growth, there's reason to believe that we may be close to a turning point, and that capital expenditure could pick up. Housing also points to potential for continued strength. Residential construction topped out at just under 7% of GDP during the boom, but today contributes less than 3% of GDP. Historically, it has averaged 4% to 5% contribution. The percentage of shared households (college graduates living with their parents, for example) is still quite high, indicating that there is room for improved new household formation, and better new housing starts. Overall, we feel pretty good about the U.S. economy and remain constructive in our outlook.
Last quarter we discussed the divergence in returns between growth-oriented and value-oriented stocks. This continued for a couple of weeks in April, but since then we've seen a bit of a recovery in growth names relative to value names. The dislocation, however, provided an excellent opportunity for initiating new positions in growth-oriented businesses. Netflix (NASDAQ:NFLX), for example, was sold off in the growth rout and bottomed in April, some 30% lower than where it had traded earlier this year. Following extensive research over the last few years, including two headquarters visits earlier this year, the sell off created our opportunity. We bought the stock on May 1st, and the stock has quickly retraced its losses.
We found other opportunities during the growth sell off. Traditionally, "hot" IPOs are exciting emerging franchise companies in the process of making their stock market debuts. As growth stocks became less interesting to investors, so did the IPO market. In this "cold" IPO environment, several companies went ahead with their offerings at lower prices than would otherwise have been the case. Value Fund shareholders were able to take advantage of the opportunity, and during late March and early April, we initiated positions in new issues Nord Anglia (NYSE:NORD), an international secondary school operator; IMS Health (NYSE:IMS), a healthcare focused informatics company; and Phibro Animal Health (NASDAQ:PAHC), a family-owned animal health business.
Overall, our stocks fared reasonably well during the second quarter, and we're excited about many of our new purchases. As mentioned above, we are constructive on the overall US economy, though complacency in the markets does temper our enthusiasm. Additionally, a few of our holdings have reached, or are approaching, their price targets. This has led to an unusually large (for us) cash balance at the end of the second quarter of just over 7%. We have plenty of ammo to put to work in new and existing holdings in the months ahead, especially if we see a pullback.